21 Aug 2017
Corporate debt in China has expanded at an unprecedented rate since the onset of the global financial crisis, to now surpass that of Japan in the late 1980s. Although concerns of a major credit event have subsided of late, the threat of one continues to loom large over the Chinese economy.
Residential property development firms are among the most leveraged in mainland China. As the chart below shows, in recent years the Chinese real estate sector has soaked up a greater share of total lending on the mainland.
Real estate sector share of total lending in China
Flush with cheap and easily accessible credit, developers bid- up land prices to unsustainable levels at auction. The chart below shows that land prices had been rising since the onset of global financial crisis, spiking in 2016 when Chinese policymakers encouraged lending to the real estate sector to support economic growth. This was done directly (bank loans), through the shadow banking sector (WMPs, trust and entrusted loans etc.), or through homeowners (mortgages).
Average land price at auction, China
As a result of the spike in premiums paid on land, many of these parcels of land that have been bid on over the past year require continued appreciation in home prices to remain solvent. However, based on projected construction schedules, as well as the Chinese government's current credit tightening policy, developers will see cracks emerging in their balance sheets from mid-2018 as traditional sources of financing dry up.
Mainland construction schedules dictate that ground has already been broken on these projects. Developers depend on pre-sales of these projects to help offset construction costs – these pre-sales would normally begin from the middle of 2018. However, as the chart below shows there is likely to be a sharp normalisation in pre-sales over the next year. This is particularly acute in second tier markets, which have seen an abundance of speculative activity.
Chinese residential pre-sales (sqm, millions)
Chinese policymakers have already begun to tighten other funding avenues for developers. The People's Bank of China (PBoC) has mandated that banks must move shadow banking activities back onto their balance sheets, which will restrict the availability of shadow financing. This will have an outsized effect on smaller developers which have less access to traditional financing and are more reliant on the shadow banking system. Similarly, policymakers have introduced several restrictions on mortgage lending.
Default pressure will begin to mount among smaller developers in second tier markets from mid-2018. What remains unknown is how interconnected the shadow and formal banking systems are and whether the prospect of a developer defaulting would spark systemic risk.
Authorities could attempt to mitigate any crisis in the short term by continuing to extend credit to developers. However, new credit faces diminishing productivity. The chart below indicates that there is evidence that more new lending in recent years has been used to pay off old loans, rather than to generate new economic activity, as the gap between loans and deposits have increased.
China loan-deposit gap
Chinese policymakers are approaching a crucial junction. They can confront the realities of excessive leverage head-on and risk financial instability, or cheap credit can continue to prop-up developers, which would likely result in a Japanese-style productivity drain over the long- term. This will be complicated by a likely leadership reshuffle during the Party’s Congress this Autumn and the retirement of the long-serving head of the central bank in January.
China has been a critical source of global demand since the financial crisis. Regardless of the path that is chosen, the implications will reach far beyond the borders of the middle kingdom.
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